What it means
A bank that lends $1,000,000 at 8% and requires the borrower to keep $150,000 on deposit at no interest has, in effect, lent $850,000 and receives $80,000 of interest on it: a return of 9.4%, not 8%. The compensating balance is the mechanism, and its effect is to convert a stated rate into a higher effective rate without changing the number in the loan agreement.
The requirement takes several forms. A percentage of the outstanding loan, maintained while the loan is drawn.
A percentage of the total commitment on a revolving facility, maintained whether drawn or not (which raises the effective cost most when utilisation is low). An average balance over a period, which gives the borrower flexibility day to day.
In some arrangements the balance is legally restricted and cannot be withdrawn; in others it is an understanding backed by the bank's discretion to review the facility, which is less binding but still effective. Banks use compensating balances for several reasons.
They increase the yield on the loan without a visible rate increase. They provide the bank with deposits it can lend to others.
They give the bank a claim it can set off against the loan if the borrower defaults, which is partial security. And they were, historically, a way of charging for services (account management, cash handling) before banks priced those services explicitly.
As banks have moved to transparent fee schedules and as competition and regulation have increased, explicit pricing has largely replaced the practice in developed markets, but smaller businesses without bargaining power and borrowers in some jurisdictions still meet it. For the borrower, the analysis is the effective rate.
The true cost of the loan is the interest paid divided by the funds actually available, and the compensating balance reduces the available funds. If the balance earns interest, the net cost of holding it is the difference between the loan rate and the deposit rate.
If the borrower would have held the balance anyway as its operating balance, the requirement costs nothing extra; if it must borrow more to fund the balance, the cost compounds. For accounting and disclosure, a compensating balance that is legally restricted must be shown separately from cash and cash equivalents (or disclosed), because it is not available to pay obligations; an informal arrangement is disclosed in the notes.
Analysts adjust reported cash for restricted balances when calculating liquidity ratios and net debt, and the compensating balance is one of the items that makes a company's reported cash overstate its available cash. The practice also appears, in different clothing, in other arrangements: cash collateral held against letters of credit or guarantees, minimum balances required by payment processors or in escrow, and reserve accounts required by lenders in project or property finance.
Each is a balance the borrower holds but cannot use, and each should be treated the same way: excluded from available liquidity and included in the effective cost of the facility it supports.
In practice
Real-world examples.
Example
A small manufacturer's $500,000 term loan requires a $50,000 minimum balance, disclosed as restricted cash in its accounts.
Example
A property developer's construction facility requires an interest reserve account equal to twelve months' interest, held by the lender and drawn to pay interest as it falls due.
Example
A company negotiating a facility replaces a 10% compensating balance requirement with a 0.25% commitment fee, having calculated that the fee is cheaper at its expected utilisation.
Think of it
“A compensating balance is money you must leave on deposit as a condition of your loan.
Formula
Calculation
Effective Interest Rate = Interest paid / (Loan amount minus Compensating balance) x 100%
With interest on the balance: Effective rate = (Interest paid minus Interest earned on balance) / (Loan minus Balance) x 100%
Where the balance is a percentage p of the loan and the stated rate is r: Effective rate = r / (1 minus p)
Loan required to have L of usable funds = L / (1 minus p)
Worked example. A distributor needs $800,000 of usable funds. Its bank offers a one-year loan at 7.5% with a 15% compensating balance held in a non-interest-bearing account.
- To net $800,000, the loan must be $800,000 / (1 minus 0.15) = $941,176; the compensating balance is $141,176
- Interest = $941,176 x 7.5% = $70,588
- Effective rate = $70,588 / $800,000 = 8.82%, or r / (1 minus p) = 7.5% / 0.85 = 8.82%
Alternative offer from a second bank: 8.25% with no compensating balance. On $800,000: interest $66,000, effective rate 8.25%. The second bank is cheaper by $4,588 despite its higher stated rate.
Variant: the first bank agrees to pay 2% on the compensating balance. Interest earned = $141,176 x 2% = $2,824. Net cost = $70,588 minus $2,824 = $67,764; effective rate = 8.47%. Still above the second bank's 8.25%.
Variant: the distributor already keeps an average of $120,000 in its current account with the first bank for operating purposes and would do so regardless. Only the additional $21,176 of balance is a real cost. The loan needed is then about $821,000 (to fund $800,000 plus the extra $21,000), interest $61,600, effective rate on the $800,000 about 7.7%. On this view the first bank is cheaper. The right analysis depends on whether the balance would be held anyway, which the treasurer must judge honestly.
Revolving facility variant: a $2,000,000 revolving facility at 7% requires a compensating balance of 10% of the commitment ($200,000) at all times. Drawn to $500,000 on average: interest $35,000; the $200,000 balance, if it would not otherwise be held, is funded by drawing $200,000 more at 7% ($14,000); effective cost of the $500,000 of usable funds = $49,000 / $500,000 = 9.8%. At low utilisation the compensating balance is a heavy charge; at full utilisation ($2,000,000 drawn, $1,800,000 usable, interest $140,000) it is 7.8%.
Disclosure: the distributor's year-end cash is $260,000, of which $141,176 is a legally restricted compensating balance. The balance sheet shows cash and equivalents $118,824 and restricted cash $141,176, and the note explains the arrangement. Its current ratio and net debt are calculated on the unrestricted figure.Case study
Seen in the real world.
A regional haulage company had borrowed from the same bank for twenty years and had never questioned the requirement to keep 12% of its outstanding loans on deposit in a non-interest-bearing account. With $3,000,000 of loans at 6.8%, the balance was $360,000, and the company's overdraft, at 9%, was drawn most of the time. A new finance manager calculated that the company was borrowing $360,000 on overdraft at 9% in order to leave $360,000 on deposit at nothing, a cost of about $32,000 a year, and that the effective rate on the loans was 6.8% / 0.88 = 7.7% before counting the overdraft effect.
She asked the bank to either pay interest on the balance, reduce the requirement, or reprice the loan without it. The bank, facing a competing offer at 7.4% with no balance requirement, agreed to remove the requirement in exchange for a 0.15% rate increase to 6.95%: a net saving to the company of about $25,000 a year once the overdraft was reduced. The finance manager's note to the owners observed that the arrangement had cost the company something over $400,000 across twenty years, and that nobody had asked because the interest rate in the loan agreement had always looked reasonable.
Watch out
Common mistakes.
- Comparing loans on stated interest rates without adjusting for compensating balance requirements, which can add one to three points to the effective cost.
- Funding a compensating balance with more borrowing (an overdraft or a larger loan) without recognising that the cost then compounds.
- Reporting a restricted compensating balance within cash and cash equivalents, which overstates liquidity and understates net debt.
Questions
People also ask.
How does a compensating balance affect the true cost of a loan?
It reduces the funds the borrower can use while interest is paid on the full amount. The effective rate is the stated rate divided by one minus the balance percentage, less any interest earned on the balance.
Is a compensating balance the same as collateral?
Not formally, but it functions partly as security, since the bank can set it off against the loan on default. Unlike collateral, it is the borrower's own cash sitting idle.
Must compensating balances be disclosed?
Yes, where material. Legally restricted balances are shown separately from unrestricted cash; informal arrangements are disclosed in the notes.
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